No doubt many advisers have been grappling with the finer details of the tapered annual allowance as the tax year comes to a close. Recent research among FundsNetwork advisers suggests around 7 per cent of clients will be affected. These will inevitably be some of the wealthiest and most important.
The research also found nearly 40 per cent of advisers had not proactively contacted clients to discuss the rules. This is particularly surprising, given the potential negative impact on their tax positions.
This first year of the tapered annual allowance will have been comparatively straightforward. Many of those affected will have had unused allowances from previous years and so could use carry forward to ensure this year’s contributions are made without penalty.
But once carry forward has been exhausted, getting the most of pension benefits becomes more complicated.
Many of those affected by the tapered annual allowance will be members of workplace pension schemes. On top of the job of working out what the tapered annual allowance is for their clients, advisers may also need to look at how they should deal with any alternative arrangements put forward by their employers. These will range from taking the employer pension contribution on offer, using an alternative savings vehicle or taking a cash payment.
Taking the employer contribution would be tax-inefficient. A tax charge of 45 per cent will likely apply and, while this can usually be paid from the pension plan, the resulting benefits will also be largely taxable.
In effect, the client would only be getting between 36 per cent and 47 per cent of any gross contribution paid depending on their tax rate in retirement.
This may be better than nothing in respect of the employer contribution, but if the client has to pay a contribution themselves to get the employer contribution, then this needs to be considered carefully.
Consider the case where the client is able to get his contributions matched by the employer. Broadly, for every £1,000 gross contribution paid by the client (at a cost of £550), he would see £2,000 in his pension plan – but would then suffer a tax charge of around £900, leaving £1,100 in the pension.
This would then be paid out, say, at 40 per cent tax, to give £770 after tax, giving a “return” of 40 per cent from the employer contribution and tax relief. Much reduced but still worth having. If the employer only matched 50p in every £1, the same £550 would only net around £580. Far less attractive.
Consider the other extreme, though, where the employer allows the contribution to be taken as cash. Often, the employer will reduce the contribution to reflect the National Insurance they will have to pay and the client will also pay NI, albeit at a modest rate of 2 per cent.
So a £1,000 contribution by the employer converts to a cash payment of around £466. This is about the same as the after-tax pension benefit would be worth if the client paid basic rate tax in retirement. If they paid more than this, the cash payment works out better.
The challenge here is that most employers will only pay out the core employer contribution as cash. With many schemes offering matching, this means an opportunity lost. Some employers have recognised this and will offer matching into an alternative investment vehicle, such as an Isa or general investment account.
Consider a one-for-one match. The client pays £1,000 from net pay (at a cost of £550) to generate a £1,000 notional employer contribution, which delivers a payment after tax and NI from the employer of £466 into the arrangement without any further tax to pay (except perhaps on income and gains earned going forward).
This gives a “return” of around 85 per cent from the employer contribution. Not as healthy as the potential “return” of 141 per cent or more that they would have got from tax relief and employer contribution into a pension arrangement without the annual allowance charge, but still a very valuable benefit.
In addition to these considerations, thought will also need to be given to estate taxes. The money in the pension should be free from inheritance tax, while the alternatives would not.
Also, if there is not an option to pay the annual allowance charge from the scheme, then sticking with the pension generally looks like a bad option.
The lifetime allowance could also be an important consideration. With the lifetime limit now at £1m, those able to make large contributions could see their pensions hit this limit sooner than they might have expected. If the lifetime allowance bites, this will reduce the returns further still.
Overall, cash will often offer better value than a straight employer pension contribution. But if there is employer matching available, thought needs to be given to whether it makes sense
to take this up.
If the matching is into a non-pension vehicle, the answer is likely to be yes. If not, then the benefit could be marginal. As always, there is plenty for advisers to get their teeth into.
Richard Parkin is head of pensions policy at Fidelity International